Monday, November 21, 2016

Denmark's Dire Pension Warning?

No country on the planet is better prepared to pay for its aging population than Denmark. But a nation whose pension industry has been ahead of the curve for decades is now bracing for a fundamental shift that most people probably aren’t prepared for, according to the financial regulator.

Jesper Berg, the director general of the Financial Supervisory Authority in Denmark, wants to warn policy makers of the backlash he says they may face once households understand the risks they run. More specifically, Berg says people haven’t grasped that they will lose money if their banks or the investments their funds make fail.

“While people applaud if money doesn’t go out of their pocket as a taxpayer, they have yet to realize that it will go out of their pocket as a depositor or pensioner or investor,” Berg said in an interview in Copenhagen. “These are enormous amounts of money, so this is an important discussion to have.”

Berg says the FSA has called for talks with politicians and industry representatives to take place in March to discuss the issue.

Privatizing Risk

Denmark’s life insurers hold more than $650 billion in assets, which is roughly 2 1/2 times the size of the economy, according to UBS’s Pension Fund Indicators 2016. At $118,214, assets per capita are among the highest in the world. In Switzerland, the figure is $98,287. In the Netherlands, it’s $79,721.

Berg says the redrawing of financial regulation since the crisis of 2008 has had some profound consequences. New solvency rules for pension funds mean clients are being pushed out of defined benefit plans and into defined contributions plans, to help providers cut their capital requirements. That helps insurers stay solvent. It also frees them to take riskier bets. But, crucially, that risk is transferred to pensioners on an individual basis.

This privatization of risk that has followed the global regulatory overhaul is “the new reality” that “we need to discuss,” Berg said.

Global Leader

Denmark’s warning is worth heeding. The country has been at the forefront of pension reform, ensuring that companies can meet their obligations and that people have enough savings to live comfortably in retirement. It’s repeatedly topped rankings in the Melbourne Mercer Global Pension Index on adequacy and sustainability.

In practical terms, the risk is that a pension fund invests in something “that makes huge losses with the result that pensioners lose money and have to live with lower pensions or stay in the labor market longer,” Berg said.

And demand for risky assets is growing as funds look for ways to generate returns in an era of record-low interest rates. Denmark’s regulator has started looking more closely at funds’ investments in less liquid assets and found that holdings of so-called alternative investments surged 66 percent from 2012 to 2015.Berg says it’s not the role of the supervisor to question the model. But he’s worried about how well it’s understood.

“While I believe in the economic incentive to privatize risk, my biggest fear is that people aren’t aware of that, and as a consequence we’ll have a backlash,” he said.

A new regulation called the prudent person principle guides funds’ investments, but it’s “still a very general principle,” Berg said. It is for the politicians to decide whether additional rules are necessary and the FSA will provide them with options, “but I just want that discussion to be taken before we have the first meltdown.”

Politicians around the world better heed Jesper Berg's warning because if they think Brexit, Trump and Marine Le Pen are all part of the anti-establishment revolution, wait till they see millions of retired people succumb to pension poverty. This will really shake up politics like never before.

More importantly, bond yields are rocketing higher and when it comes to pension deficits, it's the direction of interest rates that ultimately counts a lot more than any gains in asset values because as I keep reminding everyone, the duration of pension liabilities is a lot bigger than the duration of pension assets, so for any given move in rates, liabilities will rise or decline much faster than assets.

Will the rise in rates and gains in stocks continue indefinitely? A lot of underfunded (and some fully funded) global pensions sure hope so but I have my doubts and think we need to prepare for a long, tough slug ahead.

Trump also needs to carefully consider bolstering Social Security for all Americans and modeling it after the (now enhanced) Canada Pension Plan where money is managed by the Canada Pension Plan Investment Board. One thing he should not do is follow lousy advice from Wall Street gurus and academics peddling a revolutionary retirement plan which only benefits Wall Street, not Main Street.

You should read my comment on the global pension storm to understand why I continue to worry about global deflation, the rising US dollar and why bond yields are likely to revisit new secular lows, placing even more pressure on global pensions in the years ahead.

This is why I respectfully disagree with Bob Prince and Ray Dalio at Bridgewater who called an end to the 30-year bond bull market after Trump's victory. I have serious concerns on Trump and emerging markets and I wouldn't be so quick to rush out of bonds (in fact, I see the big backup in bond yields as an opportunity to buy more long dated bonds (TLT) and will cover this in a separate comment).

But Jesper Berg's critical point is this, as defined-benefit pensions become a thing of the past, retirement anxiety will grow as risk is transferred to pensioners, many of which risk outliving their savings and succumbing to pension poverty. This will have profound social, political and economic consequences for all countries.

And he's absolutely right, this privatization of risk that has followed the global regulatory overhaul is “the new reality” that “we need to discuss.”

Why? Because pension poverty is part of rising inequality, and along with aging demographics, these are major structural forces driving global deflation. You simply cannot have increasing aggregate demand and inflation when a large subset of the population is succumbing to pension poverty.

The other part of Jesper Berg's warning is equally important, namely, global pensions are responding to record low yields by increasingly shifting their portfolio into illiquid assets. I touched upon it last week when I covered Bob Prince's visit to Montreal:

So what in a nutshell did Bob Prince say? Here are the main points that I jotted down:

Monetary policy and asset returns are skewed (so you will see bigger swings in risk assets)

Currency swings matter a lot more in a low rate/ QE world (expect higher currency volatility)

Low rates and low returns are here to stay (expected returns in public markets will be in low single digits over next decade)

We are reaching an important inflection point where valuations of illiquid assets are nearing a peak at the same time where dollar liquidity dries up.

I emphasized that last point because it's bad news for many pensions, insurance companies, sovereign wealth funds and endowments piling into illiquid assets like private equity, real estate and infrastructure at historically high valuations.

Not that they have much of a choice. Bob Prince said in this environment, you have three choices:

Do nothing and accept the outcome

Take more risk

Take more efficient risk (like in illiquid assets)

Institutions have been taking more efficient risk in illiquid asset classes but the pendulum may have swing too far in that direction and if he's right and we're at an important inflection point, then there will be a big correction in illiquid asset classes.

Even if he's wrong, expected returns on liquid and illiquid asset classes will necessarily be lower over the next decade, so the diversification benefits of illiquid assets won't be as strong going forward.

[Note: Admittedly, this is a bit of self-serving point made by the co-CIO of the world's largest hedge fund which invests only in liquid assets. He's trying to steer investors away from illiquid to more liquid alternatives like Bridgewater but he forgets that pensions and other institutional investors have a very long investment horizon, so they can take a lot more illiquidity risk.]

Taking more "efficient risk" by investing billions into private equity, real estate and infrastructure makes sense for pensions with a long investment horizon but it's no panacea and if it's not done properly, it could spell ruin for many chronically underfunded pensions taking more risk at the worst possible time.

Pension deficits are path dependent. If your pension is chronically underfunded, taking more risk in public or private markets praying for a miracle, then that is not a strategy, that is a recipe for disaster.

What is a better strategy? Politicians need to bolster defined-benefit plans, get the governance and compensation right, bolster the social safety net (enhance the Canada Pension Plan and US Social Security) and set up a system that allows pensions to invest billions in domestic infrastructure.

Of course, pensions have a mission to maximize returns without taking undue risk. This means that if they invest in infrastructure, they will necessarily expect a return on their investment or else they are better off investing elsewhere.

I mention this because I'm a bit dismayed at some of the nonsense I'm reading from Nobel-laureate Paul Krugman warning of an infrastructure privatization scam before even seeing the details of the program. My former BCA colleague Gerard MacDonell loves praising Krugman for being 'wonderfully non-centrist' but there's is nothing wonderful about spreading nonsense on infrastructure program whose details have yet to be unveiled.

And the problem is that unions read Krugman as if he's some kind of economic god and take his economic articles very seriously (sure, he's a brilliant economist but he has a political axe to grind because Clinton undoubtedly promised him a high-profile cabinet position). When I read articles like this one on public risk, private profits, I'm disheartened by the leftist union rhetoric which quite frankly goes against what is in the best interests of public defined-benefit pensions and the economy over the long run.

Let me be a little blunt here, after all I hate skirting around an issue. Yes, we need to address the concerns of unions but we also need a reality check when it comes to infrastructure and courting pensions and private equity firms. Governments are constrained in terms of borrowing and spending and when it comes to managing infrastructure assets, I trust the people at Ontario Teachers, OMERS, the Caisse, CPPIB, PSP, and other large Canadian pensions a lot more than some government bureaucrats who do not have a profit motive.

Does this mean we need more tolls and higher user fees to pay for infrastructure? You bet it does and there's nothing wrong with this as it's not only fair for pensions looking to make long-term steady returns on their infrastructure investments, it's fair for taxpayers and it helps alleviate the fiscal burden on governments.

All this to say, Denmark's dire pension warning is real and policymakers and the elite intelligentsia better discuss solutions to the global pension crisis like adults, not like left-wing or right-wing adolescent brats that place ideology and politics over logic and what is in the best interest of pensioners and the country over the long run.

On that note, let me end by sharing this nice clip from Ontario Teachers' Pension Plan on how even minor adjustments to inflation protection can have a big impact on plan sustainability.

The future of pensions will require bolstering defined-benefit plans, better governance and a shared-risk model, which is why pensions like OTPP, HOOPP, OPTrust, CAAT and others will be able to deliver on their pension promise while others will struggle and face hard choices.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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